Unlock Editor’s Digest for free
FT editor Roula Khalaf picks her favorite stories in this week’s newsletter.
The author is head of asset allocation research at Goldman Sachs
Since 2022, when interest rates began to rise, investors have been recovering from one of the biggest shocks to their portfolios – and to their belief system of multi-asset diversification.
The surge in inflation during the recovery from the Covid-19 crisis resulted in one of the biggest losses for multi-asset portfolios in over a century. But until then, simple buy-and-hold portfolios that invested 60 percent in stocks and 40 percent in bonds were remarkably successful for the current generation of investors. Inflation has now more or less normalized. So what is the optimal portfolio for the next decade – is it okay to go back to 60/40?
Modern portfolio theory developed by Nobel laureate Harry Markowitz allows us to find the so-called “optimal portfolio” with the highest return relative to risk, including the potential for diversification. This portfolio can then be combined with cash or leveraged depending on risk tolerance. In hindsight, the 60/40 portfolio did produce the highest risk-adjusted returns since 1900, but over a 10-year rolling investment horizon, the optimal asset mix fluctuated widely and was rarely exactly 60/40.
In fact, the optimal asset mix in the three decades leading up to the Covid-19 crisis was more like 40/60. With inflation low and anchored, bonds had a strong bull market and provided diversification benefits by buffering stocks during episodes when investors adopted a “risk-off” approach. But from 2022, long-term bonds are doing poorly. While bond yields are now higher and near long-term averages, rate volatility remains high. The yield curve of bonds of various maturities is also flat. These factors suggest little benefit compared to cash alone.
As a result of the poor performance of bonds since 2022 – but also the high return of stocks – the optimal portfolio has moved close to 100% stocks over the past decade. Unsurprisingly, the question remains the value of long-term bonds in the portfolio. With more uncertainty about inflation in the coming years, as well as rising risk from fiscal policy and a higher government debt-to-GDP ratio, bonds have also become riskier.
However, holding only stocks in the portfolio seems imprudent after the strong recovery and given the increased valuations of stocks, especially in the US. Expected equity risk premiums—that is, the expected excess returns of stocks over bonds—are at the bottom of their historical range. This may reflect lingering inflation concerns or longer-term growth optimism.
We think the latter is more likely, in part because of technological revolutions like generative artificial intelligence and new weight loss drugs, but also because of the unusually high profitability of the US tech sector. During previous periods of high productivity growth, such as in the 1920s and 1950s/1960s, 20th century, stocks also outperformed bonds for long periods.
A screenshot of the interactive graphic is displayed. This is most likely because you are offline or JavaScript is disabled in your browser.
However, potential adverse trends for stocks include: deglobalization, both economic and geopolitical; decarbonisation with greater risk of commodity supply shocks and rising climate change costs; and demographic trends such as lower population growth, higher dependency ratios and income inequality.
So we see value in being more balanced again in multi-asset portfolios in the coming years. Broader diversification is necessary to diversify structural risks. The optimal portfolio for the next decade could be one-third “growth”-leaning stocks, one-third bonds, and one-third real assets.
In this portfolio, growth stocks would provide more targeted exposure to improving productivity and diversify the risk of disruption. A key challenge is that stocks tend to predict higher productivity growth than it does, resulting in valuation expansion and increased overpayment risk. With growth stock valuations already inflated, investors will have to be selective in finding beneficiaries from future technology revolutions.
Bonds would provide protection against stagnation with higher real yields. They currently expect low inflation, but if price growth accelerates, exposure to real assets in an optimal portfolio can help diversify risks. These include stocks with price strength in areas such as infrastructure, real estate and commodities. Investors could thus place an additional 20 percent of the portfolio in stocks beyond investments in growth stocks. The rest of the real assets could go into inflation-indexed bonds.
This path takes us back to a roughly 60/40 portfolio. However, the optimal portfolio for the next decade must address the potential for accelerating productivity growth and the risk of higher and more volatile inflation. This means more targeted exposure within stocks and bonds.